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Mutual Fund Flows and Performance in Rational Markets

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  • Jonathan B. Berk

    (Haas School of Business, University of California, Berkeley and NBER)

  • Richard C. Green

    (Graduate School of Industrial Administration, Carnegie Mellon University)

Abstract

We develop a simple rational model of active portfolio management that provides a natural benchmark against which to evaluate observed relationship between returns and fund flows. Many effects widely regarded as anomalous are consistent with this simple explanation. In the model, investments with active managers do not outperform passive benchmarks because of the competitive market for capital provision, combined with decreasing returns to scale in active portfolio management. Consequently, past performance cannot be used to predict future returns, or to infer the average skill level of active managers. The lack of persistence in actively managed returns does not imply that differential ability across managers is nonexistent or unrewarded, that gathering information about performance is socially wasteful, or that chasing performance is pointless. A strong relationship between past performance and the flow of funds exists in our model: indeed, this is the market mechanism that ensures that no predictability in performance exists. Choosing parameters to match the flow-performance relationship and survivorship rates, we find these features of the data are consistent with the vast majority (80%) of active managers having at least enough skill to make back their fees.

Suggested Citation

  • Jonathan B. Berk & Richard C. Green, 2002. "Mutual Fund Flows and Performance in Rational Markets," FAME Research Paper Series rp100, International Center for Financial Asset Management and Engineering.
  • Handle: RePEc:fam:rpseri:rp100
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    References listed on IDEAS

    as
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